Valuation of the Economic Impact of the Initial Allocation of Tradable Emission Permits in Air Pollution Control

Abstract

One of the key concerns about applying emission permits systems in air pollution control is the initial allocation of entitlements. In this paper, a model that captures the interaction between strategic firms and a permit-allocating authority to assess social-welfare implications of the initial allocation regimes of tradable emission permits is introduced. In particular, a three-period model is formulated for studying how the exercise of market power by oligopolistic firms affects the pollution control technology investments and, in this way, the valuation of different initial allocation proposals. The analysis shows that a proactive allocation of initial entitlements may improve social welfare with respect to a distribution that ignores the interactions between the initial allocation of emission permits and the firms’ strategic response in pollution control technology investment. The results are illustrated in the context of a sulfur dioxide emission permits system for the thermal electricity generation ...